Cyprus became the latest euro zone domino to teeter in 2012 just when the worst of the crisis appeared to be over. In March 2013, a compromise rescue plan backed by euro zone finance ministers called for Cyprus to wind down one largely state-owned bank, Popular Bank. The raid on Popular Bank was intended to raise most of the 5.8 billion euros that Cyprus was required to raise as part of the bailout.

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Cyprus bailout crisis sparks run on banks

Banks on the run with financial shockwaves spread across European Union after depositors are forced to bail out banks whose assets became too big for Cypriot economy

A customer of the Bank of Cyprus carries out a transaction at an ATM machine outside a branch in Athens. Greek branches of Cypriot banks will remain shut today, in line with Nicosia's plan for a two-day bank holiday. Photo: Reuters

The European Union finally decided to force Cyprus' savers into a bailout after the tiny Mediterranean island's banks grew so large that they dwarfed its economy - a situation alarmingly similar to Iceland five years ago.

By the end of January, bank assets in Cyprus had swollen to €126 billion (HK$1.26 trillion), seven times larger than its gross domestic product, data from the EU and European Central Bank shows. The banks had just €78 billion in 2007.

The similar imbalance in Iceland had proved to be a harbinger for the European financial crisis. Back then, Iceland's banks were no longer able to finance a debt 12 times the size of GDP and Reykjavik stepped in to seize control.

After Cyprus' banks lost €4.5 billion on Greek sovereign debt and failed to meet European capital requirements, the Cypriot government was compelled to take action itself.

Over the weekend, Cyprus announce a €5.8 billion bailout plan, including, most controversially, a big charge on small deposits that were supposed to be guaranteed by its deposit insurance scheme.

"The banks grew as they amassed funds from wealthy foreigners and now that size is too much for the country to handle on its own," said Philipp Haessler, a European banks analyst at Equinet in Frankfurt. "Cyprus is being made an example of."

The outcome caused fury on the streets of Cyprus, where people quickly emptied out the cash machines to get at their savings. By Monday morning, the jitters spread across the continent, with share prices falling in London, Frankfurt and Paris.

Cyprus - representing barely 0.2 per cent of Europe's economy - was the tail wagging the dog, creating uncertainty that raised the prospect that savers elsewhere would flee their banks.

Insiders who attended the talks said nobody seemed to want the big hit to ordinary Cypriots, but no one could find a way to prevent it. German Chancellor Dr Angela Merkel and EU officials were determined to make depositors pay.

European finance ministers ordered Cyprus to impose a levy of 6.75 per cent on deposits of less than €100,000 and 9.9 per cent on larger accounts - although that agreement was expected to face a tough vote in parliament.

As in Iceland, investors in Cypriot banks were chasing interest on deposits that looked increasingly attractive as the returns available in other parts of the euro zone declined.

In January, German Finance Minister Wolfgang Schaeuble demanded an investigation into whether Russia is using the island as a destination for money laundering. Cypriot officials deny the country is a haven for illegal money.

The banks grew as they amassed funds from wealthy foreigners and now that size is too much for the country to handle on its own. Cyprus is being made an example of

Cypriot banks paid an average 4.45 per cent on deposits of less than two years in January compared with 4.25 per cent in 2008, according to data from the Central Bank of Cyprus. During that same period, the European Central Bank slashed rates to 0.75 per cent from 4 per cent. German banks lowered theirs to 1.5 per cent from 4.01 per cent.

Of the €68.4 billion in deposits held by non-bank clients at Cypriot lenders at the end of January, €21 billion, or 31 per cent, was from clients outside the euro area, according to the Cypriot central bank.

The country's three biggest listed lenders - Bank of Cyprus, Cyprus Popular Bank and Hellenic Bank - had a total of €6.5 billion of losses in 2011 after writing down the value of their Greek bond holdings.

Russian people and companies have US$31 billion of deposits in Cyprus, according to Moody's Investors Services. More than a third of the branches of the Bank of Cyprus, which held 27 per cent of the country's deposits at the end of September, are located in Russia.

Russian businessman Dmitry Rybolovlev is the largest shareholder in the Bank of Cyprus with a 9.7 per cent stake held via a British Virgin Islands trust, according to Bloomberg data. Rybolovlev, worth US$9.4 billion, bought an apartment at 15 Central Park West, New York, for US$88 million last year.

In Moscow, Russian President Vladimir Putin called the tax "unfair, unprofessional and dangerous", while his Prime Minister Dmitry Medvedev drew comparisons with illegal forfeit.

European leaders are pushing the government to tap banks' deposits because their corporate bonds are limited in size, reducing the effect of any Greece-style haircut. The country's small tax base also hampers its ability to raise funds.

"There was no other way as there was no debt outstanding at Cyprus' banks that they could impair," said Christine Schmid, a Zurich-based analyst at Credit Suisse. "There was no option. So they went after the deposits."

From the outset, the Cypriot President Nicos Anastasiades and other member of his delegation seem to have misunderstood the determination of Merkel and other leaders to force Cypriot depositors to pay.

Schaeuble had gone to Brussels with a firm mandate from Berlin: "no bail-in, no bailout", said a member of Merkel's government. That meant: unless depositors took a hit, there would be no agreement and Germany would not contribute towards a package for Cyprus.

European officials set on a figure of €5.8 billion to come from depositors, and refused to budge. What they had not decided in advance was how much of that should come from big, uninsured depositors, and how much from ordinary savers.

Under a promise which still appears on the website of the Central Bank of Cyprus, deposits in its banks are insured up to €100,000. Cyprus has about €30 billion in insured deposits, a large amount for a country of just one million people. But because of its status as an offshore financial hub for foreigners, it also has €38 billion in uninsured deposits in bigger accounts.

Cyprus could have offered full protection to those with insured deposits up to €100,000 and still reached the €5.8 billion target by taxing uninsured deposits at a rate above 15 per cent.

According to three sources, European Central Bank board member Joerg Asmussen and euro-zone finance ministers' representative Thomas Wieser had worked on a plan that would require just that - a high levy on only uninsured deposits.

The Cypriot charge on deposits is raising concern that other European states such as Spain or Italy might levy similar one-off taxes to help rescue their troubled lenders, said Alexander Friedman, global chief investment officer at UBS in a report.

"The depositor bail-in sets a dangerous precedent, rendering deposit insurance partially worthless," he said. "While being flagged as an exceptional situation, this may accelerate problems of other weaker banks in the European periphery by increasing the risk of bank runs."

Italian and Spanish banks are smaller than their Cypriot peers relative to the size of their respective economies. Spanish banking assets total more than three times the size of the economy while Italy's banks have assets equal to more than 21/2 times gross domestic product.

"Cypriot banks aren't normal, but European policymakers should have seen it coming," said Klaus Fleischer, a professor of banking and finance at the University of Applied Sciences in Munich. "Deposits are deposits regardless of where they are in Europe. With people watching this in other countries, there's a risk they lose faith in the system."

Bloomberg, Reuters

This article appeared in the South China Morning Post print edition as no place to hide